Presentation Cost Accounting Chapter 9 16th Edition

Inventory Costing and Capacity Analysis

1. Cost Accounting Sixteenth Edition Chapter 9 Inventory Costing and Capacity Analysis Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved .

2. Learning Objectives (1 of 2) 9.1 Identify what distinguishes variable costing from absorption costing. 9.2 Compute income under absorption costing and variable costing and explain the difference in income . 9.3 Understand how absorption costing can provide undesirable incentives for managers to build up inventory . 9.4 Differentiate throughput costing from variable costing and absorption costing. 9.5 Describe the various capacity concepts that firms can use in absorption costing.

3. Learning Objectives (2 of 2) 9.6 Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate. 9.7 Understand other issues that play an important role in capacity planning and control.

4. Chapter Overview INVENTORY COSTING The two most common methods of costing inventory in manufacturing companies are VARIABLE costing and ABSORPTION costing. The choice determines which manufacturing costs are treated as inventoriable costs. DENOMINATOR-LEVEL CAPACITY Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit produced ?

5. Inventory Costing Choices: Overview Variable costing is a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. Absorption costing is a method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. You can say that inventory “absorbs” all manufacturing costs. Throughput costing is a method of inventory costing in which only direct materials are included as inventoriable costs. All other costs are expensed.

6. Inventory Costing: Differences in Income Operating income will differ between absorption and variable costing if inventory levels change because of the difference in accounting for fixed manufacturing costs. The amount of the difference represents the amount of fixed manufacturing costs capitalized as inventory under absorption costing and expensed as a period cost under variable costing .

7. Comparative Income Statements

8. Comparing income Statements for Multiple Years EXHIBIT 9.2 Comparison of Variable Costing and Absorption Costing for Stassen Company: Telescope Product-Line Income Statements for 2017 and 2018

9. Comparative Income Effects Variable and Absorption Costing

10. Absorption Costing and Performance Measurement (1 of 2) Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because: It is cost-effective and less confusing. It can help prevent managers from taking actions that make their performance measure look good but that hurt the income they report to shareholders. It measures the cost of all manufacturing resources (variable or fixed) necessary to produce inventory .

11. Absorption Costing and Performance Measurement (2 of 2) An important attribute of absorption costing is that it enables a manager to increase margins and operating income by producing more ending inventory. Producing for inventory is justified when a firm’s managers anticipate rapid growth in demand and want to produce and store additional units to deal with possible production shortages in the next year .

12. Proposals for Revising Performance Evaluation To reduce the undesirable effects of absorption costing, management can: Focus on careful budgeting and inventory planning. Incorporate an internal carrying charge for inventory Change (lengthen) the period used to evaluate performance. Include nonfinancial as well as financial variables in the measures to evaluate performance. (compare ratio of ending/beginning inventory to ratio of units produced/sold )

13. Extreme Variable Costing: Throughput Costing Throughput costing (super-variable costing) is a method of inventory costing in which only direct material costs are included as inventory costs. All other product costs are treated as period expenses. Throughput margin equals revenues minus all direct material cost of the goods sold .

14. Throughput Costing, Illustrated EXHIBIT 9.5 Throughput Costing for Stassen Company: Telescope Product-Line Income Statements for 2017 and 2018

15. Costing Systems Compared

16. Conclude Inventory Costing; Begin Capacity Concepts We have concluded the discussion of inventory costing. Now let’s move on the second part of our chapter on capacity analysis. Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

17. Denominator Level Capacity — Overview We have seen that the difference between variable- and absorption-costing methods arises solely from the treatment of fixed manufacturing costs. Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions managers face.

18. Denominator Level Capacity — Concepts Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled. In business and accounting, capacity ordinarily means a “constraint” or an “upper limit”. The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.

19. Capacity Levels Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate: Theoretical capacity Practical capacity Normal capacity utilization Master-budget capacity utilization

20. Theoretical Capacity Theoretical capacity is the level of capacity based on producing at full efficiency all the time. It is theoretical in the sense that it does not allow for any slowdowns due to plant maintenance, shutdown periods or interruptions because of downtime on the assembly lines. Theoretical capacity levels, in the real world, are unattainable but they represent the ideal goal of capacity utilization a company can aspire to .

21. Practical Capacity Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like scheduled maintenance time and shutdowns for holidays. Both theoretical capacity and practical capacity measure capacity levels in terms of what a plant can supply. Our next two levels measure capacity levels in terms of demand .

22. Normal Capacity Utilization a nd Master-Budget Capacity Utilization Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period that is long enough to consider seasonal, cyclical, and trend factors. Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period which is typically one year .

23. Effect Of Choice of Capacity on t he Budgeted Fixed Manufacturing Cost Rate The choice of capacity level can have a huge impact on budgeted fixed manufacturing cost per unit as shown here: It is possible and even likely that budgeted demand will be below production capacity levels .

24. Choosing a Capacity Level The choice of denominator-level capacity to use may differ based on the purpose for which the choice is being made. Some of those purposes include: Product costing and capacity management Pricing Performance evaluation External reporting Tax requirements

25. Product Costing a nd Capacity Management For product costing and capacity management, using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of demand for the capacity. Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity. In contrast, using either of the capacity levels based on demand hides the amount of unused capacity .

26. Pricing Decisions To understand the best choice for pricing decisions, let’s look first at the downward demand spiral for a company. It is the continuing reduction in the demand for its products that occurs when competitor prices are not met, demand drops further and the fixed costs are spread over fewer units, resulting in greater and greater costs per unit. Practical capacity, by contrast, is a more stable measure because it calculates the fixed cost rate based on capacity available rather than capacity used to meet demand .

27. Performance Evaluation Unused capacity adds costs to products. Mid-level managers have no control over those costs but do have control over prices. Should the marketing managers be held accountable for the manufacturing overhead costs unrelated to their potential customer base? (practical capacity vs . master-budget capacity utilization) Where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity .

28. Financial Reporting (1 of 2) The magnitude of the favorable/unfavorable production-volume variance under absorption costing is affected by the choice of the denominator level used to calculate the budgeted fixed manufacturing cost per unit. Recall from Chapter 4 that the production-volume variance can be disposed of three ways: Adjusted allocation-rate approach (recalculate at year end) Proration approach (spread to Work-In-Process, Finished Goods and Cost of Goods Sold) Write-off to Cost of Goods Sold .

29. Financial Reporting (2 of 2) The objective in choosing the method to dispose of the production-volume variance is to write-off the portion of the variance that represents the cost of capacity not used to support the production of output during the period. Recall that the production-volume variance = Budgeted fixed manufacturing overhead—Fixed manufacturing overhead allocated using budgeted cost per output unit allowed for actual output produced .

30. Tax Requirements For tax reporting purposes in the United States, the Internal Revenue Service (IRS) requires companies to assign inventoriable indirect production costs by a “method of allocation which fairly apportions such costs among the various items produced.” The IRS accepts approaches that involve the use of either overhead rates or standard costs. Under either approach, the IRS permits the use of practical capacity to calculate budgeted fixed manufacturing cost per unit. Further, the production-volume variance generated this way can be deducted for tax purposes in the year in which the cost is incurred.

31. Planning a nd Control of Capacity Costs: Other Issues A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are: The level of uncertainty about both the expected costs and the expected demand for the installed capacity The presence of capacity-related issues in nonmanufacturing settings, and The potential use of activity-based costing techniques in allocating capacity costs .

32. Terms to Learn TERMS TO LEARN PAGE NUMBER REFERENCE Absorption costing 330 Direct costing 330 Downward demand spiral 347 Master-budget capacity utilization 344 Normal capacity utilization 344 Practical capacity 344 Super-variable costing 341 Theoretical capacity 344 Throughput costing 341 Variable costing 330

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